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Diving Into The Nuances Of Section 121

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Most people follow the straightforward path of real estate: We buy, we own our home, we live there for a number of years, the house appreciates in value, and we sell it. Do we pay taxes on that appreciation? For most Americans, the answer is no.

This is due to Internal Revenue Code, section 121, which protects most Americans from paying taxes on the gains on the sale of their home. Essentially, section 121 allows single taxpayers to exclude $250,000 and taxpayers who are married filing jointly to exclude $500,000 from the gains on the sale of their home from taxable income.

However, section 121 has slightly different rules in the events of divorce, death or active-duty military service that are important to understand.

Section 121, which was recently recapped in a greatWall Street Journal article by Laura Saunders, is especially important today due to the current real estate market, where buyers are paying well above asking price and taxpayers may want to ease their tax burden.

Section 121’s Nuances for Divorce, Death and Military Members

As a basic overview, ownership and use tests are utilized in determining who qualifies for the section 121 exclusion. The basic requirement to qualify: You need to own and have lived in the house for 24 of the preceding 60 months. In other words, you need to live in the home for two years total (the years need not be consecutive) out of every five years to receive the exclusion.

Let’s dive into the nuances of section 121 – specifically those that relate to divorce, death and active-duty military service. 

Divorce

According to IRS Publication 523, taxpayers who were separated or divorced before selling their home can treat it as their main residence if they are a sole or joint owner, or if their spouse is living in the residence due to a divorce or separation agreement. If the home is transferred to a taxpayer by a spouse or former spouse, they can be considered an owner for the primary residence if they meet the residence requirement above (24 out of 60 months).

Also, if a taxpayer transfers their home to a spouse or ex-spouse in a divorce settlement, they won’t report any gains or losses. The exception to this is if their spouse/ex-spouse is a non-U.S. resident, in which case they’ll likely have a gain or loss and be subject to the eligibility tests in Publication 523, which can be found at irs.gov/pub/irs-pdf/p523.pdf.

Death

Widowed taxpayers may take the higher $500,000 exclusion if they sell the home within two years of the death of their spouse, aren’t remarried at the time they sell the residence, hadn’t taken the section 121 exclusion on another home less than two years before this sale, and meet the residence requirement.

IRS Publication 523 notes that widowed taxpayers may include the time their late spouse owned and lived in (even without them) the home to meet residence requirements.

One planning note: This might be odd, but in some situations, you might be better off actually selling a house after the death of a spouse in that two-year window if you plan on moving again in a few years.

Let’s say you and your spouse bought a house for $400,000 roughly 25 years ago, and the house is now worth $1.2 million. You likely will owe some taxes on the gain in the house, unless you tracked and can show the improvements you made to the home to increase your basis. But if you sold the home within two years of your spouse’s death, you would get the $500,000 exclusion plus the $400,000 basis, so you might only have a long-term capital gain of $300,000, which is still a lot. However, if you wait five more years to sell, you might increase that taxable gain from $300,000 to $550,000, since the other $250,000 exclusion would come off.

If, however, you were going to age in place and leave the home to your heirs, you might be better off not selling at all since, under today’s rules, the home would get a step-up in basis at death to $1.2 million and your heirs would owe no taxes on the sale. However, if step-up in basis rules change under the Biden administration, this could be a big planning opportunity or a trigger to move and relocate to avoid additional taxes at death or at the sale of a home.

Active-Duty Military Service

Active-duty servicepeople also qualify for the section 121 exclusion under the ownership and use tests. However, there are other considerations.

If active-duty military members must be away from their primary residence because they are on orders, the 60-month period can be extended up to 10 additional years by suspending the five-year period during active service on qualified extended duty. In other words, they can still qualify for the exclusion if they used the residence as their primary residence for two of the 15 years preceding the sale, so long as they suspend the five-year period while they are on active duty.

Qualified official extended duty is serving government orders at a duty station that’s at least 50 miles from the primary residence while living in government quarters, or for a period that is longer than 90 days.

If active-duty service members don’t meet the ownership and use tests because they’ve moved or changed duty stations, they can still qualify for the exclusion, but at a reduced amount.

For a deeper dive into each of these three areas, see Page 4 of IRS Publication 523. For a deeper dive into the military-specific rules in particular, see IRS Publication 3, “Armed Forces’ Tax Guide,” at irs.gov/pub/irs-prior/p3—2020.pdf.

Things to Consider if Utilizing Section 121

There are some things to keep in mind if you’re looking to use section 121:

  1. Track home improvements: This might be more important than ever. Put a new roof on? Track it. Updated your hardwood floors? Track it. Track whatever you’re doing to improve the home, because that will go back toward your basis and then you’ll pay less in taxes. Refer to IRS Publication 523 for the differences between repairs and improvements.
  2. Beware rising long-term capital gains tax rates. President Joe Biden proposed an increase in the capital gains tax rates from 20% to 39.6%.
  3. Plan for removal of step-up in basis. Rising house prices, along with a potential removal of step-up in basis, means we could see a lot of people have single-year income that’s higher than expected.
  4. Impact of higher-than-expected income. The removal of a step-up in basis could also lead to high taxes in single years if a house is sold and taxpayers don’t meet the section 121 exclusion limits – or they exceed them. One good example of this is the death of a spouse when there is no step-up in basis – if the surviving spouse later sells the appreciated home, they’ll pay significantly higher taxes.
  5. Review the title of the home. How you title the home with spouses can also matter in some situations. For example, under the current law, if both spouses are co-owners of the property, then depending on the state, the surviving spouse can get a step-up in basis as of the date of the death of their spouse. That could be higher depending on whether the home is in a community property state. For unmarried co-owners, each co-owner can exclude $250,000 of gain so long as they meet the ownership and use tests.

Section 121 is a great rule and it’s really important to understand. You can also speak with a professional who understands your situation and can help you navigate the process.

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